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Not Too Big to Fail

New rules on bank capital, recently proposed by the Federal Deposit Insurance Corporation and other bank regulators, are a welcome step toward a safer and sounder financial system. And they come at a politically timely moment. Big banks invariably argue that new rules will impede their ability to thrive and, in the process, harm the economy. But their profits are soaring, even as the economy slows, a situation that makes their shopworn anti-regulatory argument all the more threadbare.

It is not the banks that need protection from regulation; it is the public that needs protection from banks that are regarded as too big to fail. The new rules would require the nation’s biggest banks to hold significantly more capital than is required under international agreements. The salutary aim is to bolster the banks’ ability to absorb losses, thereby reducing the odds of failure and the need for taxpayer bailouts.

But higher capital buffers alone cannot eliminate bailout risk. Banks that are seen by investors as too big to fail — as America’s huge, complex and interconnected megabanks are — will inevitably be able to borrow money at lower interest rates than banks that are not deemed too big to fail. This amounts, in effect, to a taxpayer-provided subsidy encouraging banks to become even bigger and more complex. The trick, then, is to reduce the subsidy. Higher capital requirements are a start, but tighter regulations reducing complexity and risks are also necessary, including an iron-clad Volcker Rule prohibiting excessive speculation.

As the subsidy is pared, market pressures could further reduce complexity and risk. Trimming the subsidy will trim profits, and as shareholders get a clearer picture of how banks perform without their too-big-to-fail backing, they presumably will demand that the banks begin to operate in a leaner, more competitive fashion — including curbs on exorbitant executive pay.

It is easy to see why big banks and their executives would oppose higher capital requirements and other regulations that could curb their high-flying ways. Yet absent such rules, taxpayers and the broader economy will remain at risk for further bank failures and another financial catastrophe.